Heads up: this article is only relevant for U.S. businesses.
Tax audits can be stressful, time-consuming, and costly. While there’s no foolproof way to avoid an IRS audit, certain measures can help to reduce your chances of showing up on the IRS radar.
Account for all of your income
If you own a small business, and you do some consulting on the side, make sure you accurately report all of the money you are bringing in across your different income streams.
The IRS uses the information on Forms W-2, 1098, and 1099 to compare the income and deductions you report on your return with the information reported by others, such as employers, banks, and businesses. Any discrepancies between reported income amounts is an obvious red flag for the IRS, and will likely provoke further investigation.
Double check your return
Making a careless error on your tax return is one of the easier ways to guarantee yourself a visit from the tax man. In the event of any omission, miscalculation, or error on your return, the IRS is obligated to further investigate your case. Hire a bookkeeper to make sure your books are penny perfect, and have your CPA ensure that your return is tax-ready before you file with the IRS.
Maintain organized records
In the event that you do get audited, keeping your small business records in order will make it quicker and easier to substantiate anything that the IRS decides to question.
One distinction the IRS tends to scrutinize is the difference between a hobby and a business. Sometimes referred to as the “hobby-loss rule,” the IRS states that if you have an activity that’s not designated as a business, then the “allowable deductions cannot exceed the gross receipts for the activity.”
Keeping accurate books and using financial records to prove the legitimacy of your reported profit margin will help to show that you’re running a legitimate business, and that you are not claiming excessive deductions on a hobby.
Separate your personal and business expenses
The IRS is strict about business owners separating personal and business finances. Unless your business operates as a sole proprietorship, you are legally required to manage your business and personal expenses in separate accounts.
Having commingled expenses results in you piercing the corporate veil, and it means that creditors, including the IRS, can pursue your personal assets if your business is on the hook for any outstanding debts.
If your business and personal expenses are currently commingled in the same account, open a small business bank account and separate your expenses as soon as you can.
As well as providing an additional layer of legal separation between your personal and business assets, having all of your business expenses neatly contained in a dedicated business bank account will make dealing with an audit that much easier.
Stay consistent with your accounting method
As a business owner, you have the choice of two different accounting methods: cash basis or accrual accounting. If you bounce back and forth between the two methods, the IRS might interpret this as potentially deceitful, and it will likely incite further investigation. Whatever method you deem best for your business, just be sure to stay consistent. Failing to do so will attract the IRS to your return and potentially make you the subject of an audit.
Keep it straight—employee or contractor
When you work with hired help, it’s crucial that you properly classify workers properly classify workers as employees or independent contractors. The distinction determines which taxes need to be paid, when they are paid, and who pays them.
Generally, for an employee, you’re required to withhold income taxes and pay unemployment, social security, and Medicare taxes. With an independent contractor, you generally don’t need to withhold or pay taxes on their paychecks.
The IRS is on the lookout for businesses that intentionally miscategorize employees as independent contractors (therefore skipping out on paying certain taxes). If you frequently work with full-time independent contractors, be sure that they really are contractors and not employees. If you’re not sure whether you are working with an employee or an independent contractor, learn how to classify workers.
These methods won’t just help you avoid a tax audit—it will help you to deal with an audit swiftly if the IRS ever comes knocking.